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Among the many questions
surrounding the Federal Reserve’s programme of quantitative
easing (QE) is what will happen to the vast stockpile of bonds it
has accumulated in its efforts to lower interest rates.

Officials at the bank have
never been comfortable with their gargantuan balance-sheet. Since
2011 they have maintained that once QE has achieved its aims, the
Fed would shrink back to its former size.

As its bonds mature, the story
goes, they will disappear from its balance-sheet, along with the
money the Fed created to pay for them. A new paper by two former
advisers to the central bank, however, suggests a potential plot
twist.

The problem with the Fed’s pile of assets is that it has a
corollary in the form of a hoard of cash kept at the Fed by
banks. Banks have long been required to deposit reserves at the
central bank to ensure they can meet their daily obligations. But
since the Fed began buying bonds from them, usually by crediting
the accounts in which their reserves are held, this stash has
swollen dramatically. It now stands at around $2.6 trillion (see
chart on next page).

Of the inflation that was supposed to erupt when the banks began
lending this money there is little sign. Instead, the Fed has the
opposite problem. There are so many dollars sitting idle that
they risk interfering with the Fed’s conventional method for
setting short-term interest rates. Before QE came along, the Fed
would raise what is known as the Federal-funds rate by selling
assets and thus draining the supply of reserves, forcing banks
who need more to borrow from others. But it is hard to drive
rates up like this if banks have so much cash they need never
borrow.

Happily, in 2008 the Fed received the authority to push up
interest rates in another way, by paying banks interest on their
reserves. That discourages them from lending reserves to each
other for next to nothing. The Fed can also offer banks term
deposits and since September has experimented with "reverse
repurchase agreements", in which it in effect borrows from
money-market funds using some of its bonds as collateral. Both
instruments lock up reserves for longer periods.

In their paper Brian Sack and Joseph Gagnon argue that the Fed
should embrace its supersized balance-sheet and the tools that
come with it. It could stop worrying about the Federal-funds
rate, and instead use these new methods to control short-term
interest rates. This would have several advantages. First, the
banks could keep their mountainous reserves. They would then
worry less about running short of cash, giving them less
incentive to hoard, which should help avert spikes in rates.
Indeed, Fed research suggests the current abundance of cash
encourages banks to pay each other more promptly, making the
payment system safer. Second, if panic selling were affecting a
certain financial instrument, the Fed could intervene by buying
it without worrying whether the reserves it creates in the
process send interest rates down sharply.

To some, that may be a reason to oppose the idea: during the
crisis the Fed waded into unfamiliar markets as a last resort,
and has in theory been trying to extract itself ever since. The
new proposal looks a lot like institutionalising what is supposed
to be an aberration.

Still, it is hardly a radical plan. New Zealand has a similar
system, and the crisis forced the European Central Bank and the
Bank of England to follow its lead. For the time being, at least,
the Fed will have to continue using such measures, since it will
probably need to raise interest rates long before its
balance-sheet has returned to normal. If it likes what it sees,
supersized may be the new normal.